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Employee stock options — avoid these mistakes

By June 17, 2019 No Comments

If you work for a publicly traded company, you likely receive employee stock options as a part of your compensation package. Employee stock options can be a boon for wealth creation, especially when markets are rising. However, if not handled properly, they also represent a risk. If too much of your wealth is tied to the stock price of your employer, and the stock price goes down, so too does your net worth. The financial industry refers to this as concentration risk.

Employee stock options and concentration risk

Concentration risk is basically the old adage of not putting too many of your eggs in one basket. You’re an intelligent, proactive investor, who wants to avoid this risk. Therefore, you have a plan for selling your employee stock options (go you!) as your exercise window approaches. After your sale, you have $40,000 in net proceeds.

You decide to move $10,000 into a rainy day savings account, leaving you with $30,000 to invest in your investment portfolio. You’ve done well to limit your concentration risk in your employee stock, which is a well-known technology company. Now you need to figure out how to invest the remaining $30,000. Every individual situation is different, but in general, here are 3 common mistakes people in your situation make:

  1. They invest proceeds from the sale back into their company’s stock (such as through an ESPP).
  2. They swap out their company stock for a competitor, whose share price is highly correlated.
  3. They leave the money in cash, waiting for a good investment opportunity to present itself.

Study your ESPP plan documents

Participating in your ESPP does not lower your concentration risk. But we do recognize there can be benefits to buying your company stock at a 15% discounted rate. However, make sure you understand any restrictions on how quickly you can sell your shares after you buy them. Your company’s ESPP documents will outline any restrictions. The specifics of your company’s ESPP documents are a determining factor on if you should participate or not. Your employee stock compensation plan should account for how you will handle your stock options and your ESPP, not one or the other. You can ask your company’s HR department for a copy of your ESPP plan documents.

The idea of not putting your eggs in one basket is a simple one to grasp. Less obvious though, is the idea of not putting your eggs in similar baskets either. If you invest your assets in two different stocks in the same sector, are you really diversified? No, you’re not. Someone exercising stock options in a tech company should look to diversify those proceeds into a non-correlated investment (i.e. not other tech stocks).

Don’t swap Facebook stock for Google stock

For example, an employee of Google shouldn’t sell their employee stock options and put the proceeds in Facebook. Those are two very similar company’s whose stock prices are highly correlated. Understand that investments can be different by name, but very similar in nature. If you’re looking for some smarter investment ideas, here’s 3 etfs we’re buying right now.

The average investor makes the mistake of holding too much cash in their portfolio. The reasons for this vary, but in general, investors think they can time the market. That if they wait for the market to drop, they will get a chance to invest at a better price. Market timing is something that has been proven next to impossible.

Timing the market doesn’t work

Here’s what’s the data says is most likely to happen if you hold a large amount of cash in your portfolio:

  1. You’ll miss out on total returns from capital appreciation, dividends, and interest
    1. Over time, markets tend to rise more often than they go down
  2. If the market does start to go down, you’ll think it’s going even lower
    1. Seeing prices fall will only confirm that you were right to wait. This can tempt you to wait even longer. Thus, you miss the actual buying opportunity you were waiting for.

You must make sure your plan for handling your employee stock compensation is all-encompassing. That means having a total plan for your stock options, RSUs, and ESPP. They all contribute to possible concentration risk and should be thought of collectively. Moreover, your plan needs to include what you will do with proceeds from any sales in your company’s stock.

You want to be sure to divest the proceeds from those sales into non-correlated assets. Selling your employer’s tech stock in favor of another tech stock rarely reduces your overall risk. And remember that cash has typically underperformed other assets due to inflation. Stocks, bonds, and real estate have all made for better investments versus cash in the long-run. If you have employee stock options and are looking for some guidance, contact us.

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